Government Contracts Monitor
Royalty-in-Kind Contracts With The Department of the Interior Can Be Enforceable Federal Contracts
October 7, 2013
Companies that extract minerals and other natural resources from federal land typically pay royalties to the U.S. Department of the Interior (“Interior”). Under standard federal oil and gas leases, the government may enter into Royalty-In-Kind (“RIK”) contracts providing that the government receives a designated proportion of the minerals extracted instead of a cash payment by the company operating on federal land. In Rockies Express Pipeline, LLC v. Salazar, No. 2012-1055 (Fed. Cir. Sept. 13, 2013), the U.S. Court of Appeals for the Federal Circuit found such RIK contracts to be enforceable.
In 2005, Rockies Express Pipeline, LLC (“Rockies Express”) set out to build a $6.8B pipeline to ship natural gas from Wyoming to Eastern Ohio. The pipeline was to be built in two phases: Rockies Express West (from Wyoming to Missouri) and then Rockies Express East (from Missouri to Ohio). In exchange for building the pipeline, Interior agreed to pay Rockies Express a reservation charge for at least ten years per section, reserving 2.5% of the gas shipped on the pipeline. Interior would receive the natural gas as a royalty-in-kind for gas Rockies Express extracted from federal land in Wyoming. Interior agreed to pay reservation charges of $1,207,540/month for Rockies Express West and $1,663,800/month for Rockies Express East. The reservation charges created firm transportation capacity for Interior’s reserved natural gas and were designed to enable Rockies Express to recoup some of its pipeline construction investment. The parties intended the relationship to extend at least ten years following the completion of each section of the pipeline.
To memorialize their agreement, Rockies Express and Interior entered into a Precedent Agreement. Attached to the Precedent Agreement were copies of two separate Firm Transportation Service Agreements (“FTSA”), one each for Rockies Express West and Rockies Express East. The Precedent Agreement obligated Rockies Express and Interior to sign the designated FTSA after each section of the pipeline was completed.
Rockies Express West was completed and Interior signed the related FTSA in April 2007. Interior shipped gas on Rockies Express West for over a year without incident, including during the time construction was progressing on Rockies Express East. In May 2008, just before Rockies Express East was completed, Rockies Express sent Interior the relevant FTSA for signature. Interior refused to sign the FTSA that was attached to the Precedent Agreement and attempted to renegotiate a new one with Rockies Express. The parties could not agree on a new FTSA. As a result, Rockies Express terminated the Precedent Agreement in December 2008 on the grounds that Interior was in material breach for failing to sign the FTSA that was attached to the Precedent Agreement. Interior then stopped shipping gas on Rockies Express West and refused to ship any gas on Rockies Express East when it opened.
Rockies Express filed a claim against the government over Interior’s breach. The claim was initially heard by the Civilian Board of Contract Appeals (“CBCA”). The CBCA found that Interior breached its contracts with Rockies Express and awarded it $3,542,121 in reservation charges for Rockies Express West and $3,319,104 in reservation charges for Rockies Express East. The CBCA denied Rockies Express’s claim of $173,230,601 for the full ten-years-worth of reservation charges. Both Rockies Express and Interior appealed.
The U.S. Court of Appeals for the Federal Circuit made several significant rulings. First, it held that the Precedent Agreement, with its contractual obligations to enter into specific and attached FTSAs for the transportation of natural gas, was an enforceable contract under the federal Contract Disputes Act. Second, it held that while ten year contracts are typically illegal under the Federal Acquisition Regulations (“FAR”), the Precedent Agreement was not subject to the FAR and hence there was no illegality. In support of this point, the Court noted that Interior “cannot escape liability on the grounds that the same contract provisions in Rockies Express West for which it assumed liability are illegal in Rockies Express East. It follows that if Rockies Express can recover under the Rockies Express West FTSA, it should also have a remedy for Interior’s breach related to the Rockies Express East FTSA.”
Finally, the Court, after agreeing that Interior was in breach of contract, threw out the CBCA’s damages award as being inappropriately limited in scope. The CBCA had limited Rockies Express’s damages to those damages incurred prior to October 31, 2009 – the date Interior said it could have otherwise lawfully terminated its entire RIK program through an agency-wide policy change banning RIK contracts. The Court ruled “that Rockies Express is entitled to compensatory damages designed ‘to put [it] in as good a position as that in which [it] would have been put by full performance of the contract.’” Instead of automatically granting Rockies Express the full $173,230,601 it claimed, the Federal Circuit remanded the case for a calculation of damages. In doing so, the appeals court cautioned that:
Rockies Express is requesting not only its profits throughout the full term of the Precedent Agreement, but also the costs it avoided having never shipped natural gas to Interior on the Rockies Express East. Recovery of the full contract price presumes that Rockies Express was unable to find another shipper willing to assume Interior’s 2.5% reservation after undertaking reasonable efforts. . . . Nevertheless, we hold that Rockies Express is only entitled to “recover its pecuniary loss of anticipated and unearned profits” for the contract term, not the entire value of the contract when it includes costs avoided or offsets gained through mitigation.
In other words, Rockies Express should be able to get a judgment much larger than the approximately $7M judgment awarded by the CBCA and much closer to its claimed $173,230,601, provided Rockies Express can show proper deductions for mitigation efforts and other avoidable costs.
Michael J. Schrier is the attorney responsible for the content of this article.